Some segments are trading at extremely low valuations making them a good contrarian bet.

In Why India has embarked on a long term bull market series, I had laid out my thesis on why the Indian stocks are set for a long term bull market. A number of analysts also concur that the Indian market is set on a long period of sustainable growth. Now the main question is how to take advantage of this bull market and which are the sectors and companies one should invest in to gain the maximum leverage. In my earlier articles, I had written about the defense manufacturing and energy sector themes. The other major sector which will show sharp growth is the financial sector. The financial sector of an economy generally grows at a multiple of the GDP growth rate. Given that most forecasters are predicting medium term growth rates of 7-8%, the financial sector should show sharp gains. There are already some great stocks listed on the US stock markets, which have given multibagger returns over the years. HDFC Bank (NYSE:HDB) and ICICI Bank (NYSE:IBN) are two of the finest run financial companies in India. HDFC Bank sports one of highest valuation ratios amongst the major global banks (P/B of more than 4) because of the high quality of its management, past growth, strong assets and future potential. There are also some new strong players whose potential has not been realized by the investors yet. The Indian financial sector can be divided into 3 main segments - a) Private Banks, b) Public sector banks and c) Non-banking financial institutions (NBFCs).

Current Situation of the Financial sector

The Indian financial sector is also seeing major reforms like the rest of the economy. The Prime Minister has put a lot of emphasis on improving the financial inclusiveness, by getting more and more people to register bank accounts under the Jan Dhan Yojana. This is being done so that subsidies can be directly transferred to beneficiaries which will prevent leakages. The government owned banks have been on a massive drive to enroll the villagers and poor by giving sops, such as free insurance and zero balance accounts. India also is fortunate to have one of the central bankers Raghuram Rajan at the helm of the Reserve Bank of India. He has managed to curtail high inflation and stabilized the foreign exchange rate. The private sector banks are doing quite well with low levels of NPAs and good growth rates. The public sector banks are trading at extremely cheap valuations as they are saddled with high NPAs, due to the distress in the infrastructure sector. Majority of the loans made during the boom period in 2008-2009 have turned bad, as many infrastructure projects got stalled due to lack of clearances, project delays as well as bad policy making.

Private Banks - This has historically been the best performing segment in the Indian financial sector. India nationalized the whole banking sector in the 1970s. During the economic liberalization in 1990, licenses were given to a few banks like HDFC and ICICI. These banks have performed extremely well. Other private sector banks like Kotak Mahindra, Indusind and Yes Bank have also shown tremendous growth in the last few years. There are also some small private banks like DCB, City Union Bank etc. which have shown muted growth. The large and medium private banks are great stocks to invest in, as they have done well both in boom and bust periods. Their consistency has been quite amazing and their management quality has been quite strong. The only downside is that their valuations are quite expensive, with P/B ratios ranging from 2-4x.

Government Banks - India has a number of government owned banks (around 30), which came into being after the financial sector was nationalized in the 1970s. These banks are trading at extremely low valuations, due to the massive problems of non-performing assets (NPA). The low fiscal and monetary stimulus given during the Lehman crisis in 2008 has come back to bite these banks. The power, cement and steel sectors are under a lot of stress, due to unavailability of raw materials, delays in regulatory approvals and a general slowdown in the economy. Many of India's large infra groups such as Lanco, JP Associates, and GMR etc. had taken out huge loans to fund their large infrastructure projects. Majority of these loans have become delinquent. Many of these PSU banks have reported large losses in previous quarters. Some of them are surviving (e.g. United Bank of India) only due to government support. These banks are also known for high level corruption like other government sector owned companies, as many loans are made due to political connections. The silver lining to all this is that, many of the better PSU banks such as State Bank of India (NYSEMKT:SBI), Bank of Baroda etc. are trading at cheap valuations. It might be a good contrarian bet to buy some of these stocks at their cyclical lows.

Non-Banking financial institutions - Non-banking financial institutions (NBFCs) are generally not allowed to take deposits from the retail investors. They are dependent on wholesale funding for their operations. There are also not constrained by the central bank to keep reserves and do not have sector commitments to weaker sections. In India, there are industry focused NBFCs, for e.g. PFC and REC are power focused NBFCs, while Dewan Housing and HDFC are housing focused NBFCs. Some of these companies are run extremely well and have shown good growth in the past. They have very good credit appraisal systems and make good margins. Housing and auto finance NBFCs are good buys, given the strong growth expected in these sectors.

Negatives

Increase in competition - The government is planning to liberalize the process of giving license to new banks, as well as allow new banking institutions such as payment banks. This will introduce more completion into the sector and compress the high margins of the existing players.

Oil price increase and a deficient monsoon - The financial sector has been performing well, as Indian inflation has been falling and the central bank has been cutting interest rates. However oil prices have increased since falling to all-time lows. There is also a strong possibility that the monsoon rains will be deficient this year, leading to an increase in food prices. Higher inflationary pressures will prevent the central bank from cutting rates. This will decrease the credit growth for the Indian banks.

Which stocks to invest in

ICICI Bank and HDFC Bank are the obvious candidates to invest in, given that they are listed in the US markets and are fundamentally very strong companies. There are also some very good stocks such as Axis Bank and Yes Bank listed in the Indian stock markets. Some of the better NBFCs to invest in are Dewan Housing, GIC Housing Finance etc. Investors with a strong risk appetite can also look to invest in SBI, Bank of India and Punjab National Bank.

Summary

The Indian financial sector is set to grow in mid to high double digit rates over the next 15 years, as India grows to be the world's third largest economy by 2030. India's current low level of development (per capita income range of $100-1500), as compared to the other middle income countries (China, Brazil, Russia) and a good government are the biggest factors behind these growth projections. Vast sections of the population do not have access to modern financing. The current bank consumers will also require more credit and depository products going forward. Some companies have proven themselves over the past 10-15 years, in terms of growth consistency and high quality of earnings. There are also some new financial companies that have good growth potential. Investing in India's financial sector is a no-brainer at the current point of time.

Disclosure:The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold HDFC and ICICI bank stocks in the form of mutual funds in India.